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The
Convertible Bond: A Possible Solution to the Problem of Reducing
State Ownership in the Chinese Background Without any doubt, the Chinese stock market has seen dramatic development in the past decade. According to the February 24, 2002 issue of International Finance, the Chinese stock market had a total 1160 stocks (646 in Shanghai, and 514 in Shenzhen) listed at the end of 2001. Simply in terms of the number of listed companies, China is ranked number three in Asia. China's initial goals when starting the stock market were as follows: (1) to raise capital; (2) to modernize company business mechanism; (3) to optimize capital allocation; and (4) to diversify business risks. After more than a decade, the first goal has clearly been met. The stock market has become an important means for companies to raise capital in the past 12 years. The same report in International Finance says that from 1991 to 2001, a total of 772.7 billion yuan (including about U.S. $22.8 billion from overseas) have been raised through stock issuance. However, the market has not functioned as well as a means to optimally allocate social resources and provide incentives to company management. A major reason, among others, is that the dominant state ownership of companies has led to insufficient corporate governance. When a company has a large owner controlling the majority of shares, small investors will not be able to influence the company's management. Due to historical reasons, about 65% (340.49 billion out of 521.8 billion shares) of the shares, the majority of which are owned by the government, are not available for trading. Therefore, public companies still behave as if they were managed as affiliations of government agencies, and the capital raised from the stock market has often been used in projects different from those claimed in the companies' prospectuses. Public companies have been regarded as top winners in the stock market, while they have generated little return to investors and the majority of investors in the secondary market have been losing their wealth (Xiao, 2002). As investors become more sophisticated, the low quality of listed companies may even threaten the market's capability to raise capital. In fact, many companies' refinancing plans have met resistance lately. In 2001, over 150 companies had to stop their refinancing plans, while some others greatly reduced their refinancing amount or new share prices (Liu, 2002). To improve market efficiency and fairness, reducing the state ownership of public companies has been regarded by many as a priority in the development of China's stock market. On June 12, 2001, the government approved a state ownership reduction proposal, which was terminated only four months later. Clearly, the plan had fundamental flaws and adversely impacted the stock market: in the four months from mid-June to mid-October, the Shanghai A Share Index and the Shenzhen A Share Index dropped by about 31% and 33% respectively. Lu (2002) believes that the reasons for the failure are two-fold. Firstly, the plan did not clearly specify the speed and scale of the reduction, and such uncertainty had generated panic in the market. Secondly, due to the non-floatability of most shares, the stock prices had been inflated and unilaterally set by the seller, the state government, before the plan was implemented. Currently, the central government is preparing a new round of reduction with a deadline set at around the end of March 2002. Undoubtedly, the government is steering in the right direction by being persistent in reducing the state ownership of publicly listed companies. With less state ownership, the ownership profile of public companies will become more diversified, which will help strengthen corporate governance and improve corporate efficiency. Moreover, the proceeds from selling state-owned shares can be channeled to the badly needed social security fund. The benefits notwithstanding, the question remains as to how to implement the reduction plan. As the original owner, the government does not want to see the value of its assets shrink during the equity transfer process. On the one hand, it is obviously wrong to price the state-owned shares simply based on a company's net asset value per share, since doing so would ignore the company's earning prospect. On the other hand, the experience in 2001 proved that simply pricing state-owned shares at existing market prices is not feasible, either. Le (2002) criticizes that, while companies have not added much value through earnings generation, the value of the state-owned shares appreciates twice through the process of going public: pre-IPO (initial public offering) asset valuation tends to over-state a company's value, and IPO pricing tends to place an additional premium over the pre-IPO valuation. Current price-to-earnings ratios in the market are reflective of such high valuations. After all, only 35% of the total outstanding shares are free floating. If the supply of freely floating shares is doubled, market prices are doomed to decline. The Economic Daily, reported on February 2, 2002 that Chen Qingtai, Deputy Director of the Development Research Center under the State Council, stated that the reduction of state ownership in publicly listed companies would be a long-term task. Meanwhile, the government has reached a consensus over four principles: (1) All shares should be freely floating. (2) Current non-state owners should be compensated. (3) There should be no more differentiation in share floatation for new public companies. (4) Share prices should be set based on companies' quality (Li 2002). Since the government is planning to start a new round of reduction in April, there has been a hot debate among Chinese economists and government officials about how to create an "all-win" plan. The discussions thus far have focused on how to transfer the shares directly to the general public, whether to allow the transferred state-owned shares to float in the market, and how to directly price the state-owned shares, etc. Against
the backdrops of restructuring state-owned enterprises and
transferring the state-owned shares of publicly listed companies
to the general public, the article proposes that convertible
bonds should be introduced to the Chinese financial market.
Convertible bonds give their holders an option to exchange each bond for a pre-specified number of shares of common stock of the company under certain conditions. The pre-specified number of shares for each bond is called convertible ratio. Bodie, Kane and Marcus (1995) illustrated the features of a convertible bond through the following hypothetical example. Suppose a convertible bond that is issued at par value of $1,000 is convertible into 40 shares of a firm's stock, implying a conversion price of $25 per share. If the current stock price is $20, the option to convert is not profitable, and the bondholder will hold the bond and choose not to convert. If the stock price rises to $30, it would become profitable for the bondholder to convert the bond into shares, since each bond can be converted into $1,200 worth of stock, compared to the bond's face value of $1,000. Therefore, convertible bonds give their holders the ability to share in price appreciation of the company's stock. When first issued, convertible bonds offer lower coupon rates than nonconvertible ones. To the bond issuer, it is more cost effective. However, the actual return on the convertible bond has the potential to exceed its stated yield to maturity given its convertibility feature. Meanwhile, the straight bond value acts as a "bond floor," since even if the stock price stays low during the whole holding period, a bondholder can still retain the bond's value. Thus, a convertible bond provides a downside protection for the investors. In the Western countries, convertible bonds tend to be issued by smaller and more speculative companies, because it is costly to assess their business risks and there are concerns that the company management may not act in the bondholders' interest. Notice that convertible bonds represent unsecured and generally subordinated debt. Very often, the issuer is in a new line of business, making it difficult for investors to assign a fair discount rate by assessing the probability of business failure and bond default. The convertibility feature aligns the interests of the holders of convertible bonds with those of the company's management, allowing the investors to profit when the company's share price rises and to minimize losses when its share price falls. The
following is an example of how convertible bonds can operate
in China. Suppose that company ABC announces that it will
issue convertible bonds with certain conditions attached for
possible conversion into certain percentage of its state-owned
shares. To protect its own assets, the government can set
a low conversion ratio, or high conversion price. This high
price can be regarded as a target for company management to
reach in the future. Investors can express their satisfaction
or dissatisfaction with this arrangement by trading the bonds
at higher or lower prices. The bond prices can help the government
determine how to sell the next round of assets. If the conversion
does not come true by the bond maturity date, bondholders
get back their principals plus interest payments. The state
government keeps the equity and waits for the next opportunity.
If the company has failed to reach its target share price
once, it would have to pay a higher interest rate when they
issue bonds the next time. To further protect investors, the
term of the bond can stipulate that the convertible bond can
be called, or bought back by the company at a pre-specified
price. That is, even if it is not profitable to convert into
equity, investors are guaranteed to have a certain level of
returns. The convertible bond has the following advantages over other proposed strategies: (1) It can protect the value of state-owned assets from diminishing during the asset transfer process. This seems to be the top concern for the government, the current owner of the assets. The key is how to price the state-owned shares fairly. Last year's experience showed that fixing the share price at the current market level is wishful thinking at best, given the small proportion of Chinese stocks that are currently floating. After all, when a huge supply of stocks emerges, the invisible hand will adjust prices downwards, which will hurt investors. On the other hand, the government would not accept low prices at its own expense. By issuing convertible bonds with long periods to maturity (between three and five years, according to the new government regulation), the government can let the market determine the price, though it can retain the power to set the convertible ratio. Given the convertibility feature, investors would be willing to pay a higher premium. Even if the market price were below the preferred value for the government, it would represent the true economic "intrinsic" value of the stock. Furthermore, the government can choose the optimal timing and size of the issuance when issuing bonds. The government can gradually issue bonds while learning market's reaction. Another beneficial feature of the convertible bond is that it can be callable at the discretion of the issuer. Essentially, both the bond issuer and holder hold options on each other. While the bondholder hold a call option to buy the stock, he writes a call option to have the bond repurchased by the issuer. The opposite is true for the issuer, too. Thus, there is a two-way traffic here. The government can always decide to exercise its call option to repurchase the bond before the bond matures, if it decides it is in its interest to do so. With such flexibility, the state-owned assets are further protected. (2) The impact of the reduction plan on the current stock market can be minimized. No matter how state-owned shares are transferred to private investors, the plan would open the floodgate for a huge increase in the number of shares traded in the market. (Remember that on average, 65% of total shares are not floated right now). It is inevitable that share prices would drop and that current investors would suffer. By issuing convertible bonds, however, the companies would create a different market that does not directly compete with the existing stock market within a short period of time, because the bond feature of the new financial instrument would attract investors with different risk preferences than those investing in stocks. (3) After the issuance of convertible bonds, it is natural to have a secondary market for them to provide liquidity for investors. China has a very small debt market compared to its stock market. So far, only eleven state government bonds and eighteen corporate bonds are traded in the market. Corporate bonds currently have little trading volume. However, an expansion of the debt market is much needed. A recent survey by the People's Bank of China shows that the proportion of households holding state government bonds has been growing, and that the increase in the number of bond investors was faster than the increase in the number of stock investors in the second quarter in 2001 (Zhang, 2001). The Convertible bond as a financial product is not a completely new concept to the Chinese market, but as more companies issue convertible bonds, a larger market would pique demand for new talents. Many Chinese financial professionals and graduate students have studied option-pricing theory in depth. The convertible bond market would provide playing fields for them to hone their expertise. For general investors, this new market would provide them with another conduit to diversify their investment portfolios. (4) Bonds in general place "hard" constraints on companies. It is a company's obligation to repay interests and principals on its bonds, while it is easier for them to defer dividend payments on its stocks. Nevertheless, there have already been instances where bond issuers defaulted, and the debt was repaid by the bank that underwrote the bond issuance. These incidents signal that any bond issuer and its underwriter need to consider the issue of credibility seriously. Since 1995, companies have relied on issuing far more stocks than bonds to raise funds (Xu, 2001). To a certain degree, this very fact shows that Chinese companies have taken the financial market just as a tool to raise capital without much consideration of optimal capital structure and their own accountability to shareholders. In other words, the Chinese stock market currently lacks the ability to discipline a company's management. To encourage more new bond issuance, the Chinese government is considering a more market-oriented system to authorize a company to issue corporate bonds. The new government rules stipulate that a convertible bond issuer has to be a publicly listed company with a debt-to-equity ratio of less than 70%. Currently, only 85 publicly listed companies out of a total number of 1160 are qualified. The first round of companies to transfer the state-owned assets will be limited to these companies. Others will have to improve their business performance before they can use the financial market to raise funds again. Even for those companies that are qualified to issue bonds right now, the inclusion of a buy-back clause would at least help reign in management excesses. Take the recent Tyco's debacle as an example. Tyco International is a U.S. manufacturing and service company. Recently, its stock price plummeted due to accounting malpractice similar to Enron's. It issued convertible bonds in 2000 and 2001. In both issuances, Tyco promised to buy back the bonds at certain prices if the bonds cannot be converted. Right now, the company's stock price is far below the price that would induce investors to convert the bonds and therefore, its convertible bond prices are far below the pre-specified buy-back prices. Yet, the company has to honor its promise to protect investors. With this hard constraint, any rational company management would exercise caution when issuing more bonds and pay more attention to business efficiency. On the other hand, investors can be less worried that the company's sole incentive to issue convertible bonds is just to "collect money." In summary, issuing convertible bonds is a possible solution to the problem of reducing state ownership in publicly listed companies in China. Of course, the strategy's success requires that every step in the process strictly adhere to principles of market economy. Otherwise, the new bond market will repeat the same mistakes and problems as the stock market has seen. Zhong (2001) warns of the possibility that companies may use convertible bonds as a new means to "collect money." Meanwhile, investors should be aware of the risk of convertible bonds, as with any other financial instruments. When the issuing company goes bankrupt, convertible bonds are subordinated debt, meaning their holders can only get compensated after the senior creditors. Restrictive clauses should be imposed in the debt contract to avoid companies' mismanagement of capital as mentioned by Zhong (2001). (Qianli Wu is a portfolio manager at the Rydex Funds. The views expressed here are those of the author, and should not be attributed to Rydex. The translation of Chinese new agencies and news titles may not be accurate.) Reference: |